UC Davis Agricultural and Resource Economics

Nick Hagerty, Massachusetts Institute of Technology

Liquid Constrained in California: Estimating the Potential Gains from Water Markets

Date and Location

Friday, February 2, 2018, 10:30 AM - 11:50 AM
ARE Library Conference Room, 4101 Social Sciences and Humanities


Water markets may help societies adapt to rising water scarcity and variability, but their setup costs can be substantial and their benefits uncertain. I estimate the gains available from an efficient statewide water market in California, where most of the necessary physical infras- tructure exists, yet transaction volume remains low. I develop a four-step empirical approach that exploits observed choices in the existing water market, and I apply it to comprehensive new data on California’s water economy. First, I estimate transaction costs that arise from ob- servable factors, such as regulatory reviews, by comparing prices across transactions – made by the same user in the same year – that are and are not subject to each factor. Second, I re- cover equilibrium marginal valuations of water using a revealed-preference condition: marginal valuations must be as high as the highest price paid (or as low as the lowest price accepted), after adjusting for observable transaction costs. Third, I estimate price elasticities of demand by exploiting supply shocks driven by weather and amplified by historical allocation rules. Finally, I combine marginal valuations and elasticities to construct demand curves and simulate coun- terfactual equilibria. I find that observed trading in California’s existing water market generates consumer surplus of $150 million per year, an amount roughly equal to the annual market value of sales. An intermediate market scenario, in which all participants trade the same percentage of their water as today’s highest-exporting region, would create additional benefits of $480 mil- lion per year. A fully efficient market would achieve even larger gains, which can be weighed against the benefits of existing regulations and the costs of further strengthening markets.

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